The housing market has been a hot topic during the past several years, with mortgages and home valuation at the forefront of the conversation. Most recently, the media has focused on a structure available for homeowners who still have home equity. This structure is intended to boost retirement savings using that equity while gaining a tax break at the same time. I'm not talking about a reverse mortgage or downsizing to a less expensive home. Both of those strategies are most applicable at or near retirement age. There's a strategy that could allow more immediate action under the right circumstances.
I'm talking about a leveraging strategy: leverage the value of a home to generate tax benefits and bolster retirement savings. As with any leveraging strategy, the positives are magnified if everything goes well; and if something goes wrong, leverage can make a bad situation worse.
For people with positive equity in a home, a good credit score and a secure source of steady income, the strategy starts with a home equity loan against a residence. Then the investor would re-route income into a tax-sheltered retirement account - like a 401(k) or IRA - and use the home equity loan to replace the income. This provides a three-pronged benefit:
- Increased tax deduction for mortgage interest expense;
- A reduction in taxable income from increasing contributions to a tax-sheltered retirement account; and
- More money invested to grow over time.
This strategy isn't for everyone, though.
In the current lending environment, a great credit score and sizeable positive equity are necessary to qualify for a loan - plus sufficient income to make the additional loan payments.
And remember that leveraging can put you in a bigger hole if your financial situation takes a negative turn. For example, say you decide to take a loan on your home to increase contributions to a tax-sheltered retirement account, but then you lose your job. Because of the additional loan, your monthly expenses are higher. And since you've been focusing your saving efforts on tax-sheltered accounts, you won't be able to access the money without penalty until age 59½.
There's also a risk that the value of your home could fall below the value of the outstanding loans, which could limit or even completely prevent you from selling your home.
Additionally, there is the risk that the annualized return on your retirement account may be less than the net interest expense on your home equity loan, thereby leading to loss for the overall strategy.
You should also be aware that diverting part or all of your current available home equity for the purpose of gaining additional exposure in equity and fixed income instruments may result in a loss of overall diversification of your net worth. Consequently, you may become more reliant upon market based returns to fund your retirement needs than might otherwise have been the case had you not utilized this proposed strategy.
This strategy may make the most sense for certain self-employed individuals because of the larger individually deductible contributions allowed in SEP IRAs, Solo 401(k)s and other plans commonly used by small business owners. The contribution limits of both plans are $50,000 for 2012, versus $17,000 for standard 401(k) investors. However, as previously discussed, issues caused by any negative changes in a self-employed individual's income could be exacerbated by both higher monthly expenses associated with a home equity loan and the loss of short-term liquidity relating to the funds deposited into that individual's retirement account.
Using home equity to fund retirement isn't notably advantageous if you don't itemize tax deductions or if you're already maxing out retirement plan contributions.
If you think this sounds like a specialized strategy that would only work for a select set of investors under certain favorable conditions, you're right.
My intent isn't to encourage everyone to take a home equity loan to boost retirement savings. This strategy isn't for everyone. What I want to convey is that there are many ways you could save more for retirement. But it doesn't have to be complicated. For many, the best route may be contributing regularly to a 401(k) or IRA and working to create a tighter budget to free up more of your paycheck.
What strategies are you using or thinking about using?
If you'd like to discuss your retirement strategy, contact our adviser team at 877.627.8401.
Charlie Koch, MBA, CFP®, CFS®
Senior Investment Adviser
*Nothing in this article should be construed as tax advice. Contact a qualified tax professional to discuss any tax matters relating to your retirement plan investment options.
Smart401k is a web-based investment advisory service providing unbiased recommendations to help people invest in employer-sponsored retirement plans. Smart401k provides service to nearly 11,000 clients who collectively have more than $2 billion in assets. Plan participants receive personalized, fund-specific investment recommendations and the support of professional investment advisers available to discuss all investment questions. Based in Overland Park, KS, Smart401k is online at Smart401k.com.